4/29/2010 @ 5:59PM

The U.S. Needs Real Financial Reform

The heat is on financial regulatory reform this week as Democrats and Republicans jockey for who is protecting the taxpayers from the big bankers. After two successful efforts to block debate on the Democrat’s proposal, the Republicans have agreed to let the bill move to the floor of the Senate. As the amendments fly, and deals are made and sorted out, both parties will claim that they are pushing for real financial reform that will prevent another crisis or future bailouts from happening.

Unfortunately, it just isn’t so. The truth is that Congress and the Obama administration have not given the American people anything close to real financial reform. The 1,300+ page Dodd bill, to quote a famous Boston Globe headline, is simply mush from the wimps. Sure, some of the proposals go in the right direction–we need to regulate derivatives, someone needs to be thinking about systemic risk, and we ought to clean up the byzantine system of consumer protection. But on almost every significant issue, our elected officials, Democrats and Republicans alike, ducked. We’re left with spin.

Let’s step back and remind ourselves how we ended up pouring trillions of dollars of government money to bail out one of our country’s most notoriously profitable industries. In many ways it is really simple. We had a housing bubble (and more generally an asset bubble) in which there was mass delusion that housing prices would just keep going up. Almost everyone partook in this hysteria, from immigrants hoping to secure the American dream the old fashioned way–home appreciation–to rocket scientists on Wall Street who used historical data to predict that a price decline was as probable as a volcano erupting in Iceland and shutting down air traffic.

When the bubble burst, two things happened. The highly interconnected financial system started imploding. Plummeting asset values revealed, tautologically of course, that people had made a lot of bad bets. The cratering markets also showed that businesses had engaged in stupid, and sometimes criminal, behavior that would have been covered up if prices had kept going up. As Warren Buffett observed, when the tide goes out, you find out who’s swimming naked.

We’ve had bubbles as long as we’ve had financial markets. At least as of today there’s very little understanding of how to predict them or how to make sure we listen to Cassandra the next time she announces one of these. Remember, many smart people didn’t think we were in a bubble even though, in retrospect, it is clear that we were.

It is nevertheless obvious that there were massive breakdowns in our financial regulatory system. A better system could possibly have averted the crash or, more likely, enabled government and private institutions to handle it far better. Whenever those issues are raised in D.C. our elected officials seem to jump under their desks.

Here’s a big one that no one is dealing with. The financial regulators–the government officials who were actually responsible for regulating the financial services industry–were abject failures. We don’t need to focus on SEC officials surfing the Web for triple-X videos. These are the guys and gals who completely botched looking into the Madoff and Stanford Ponzi schemes. Regulatory after regulatory agency, there’s the same story.

Before we add even more regulation to one of the most extensively regulated industries in the economy we need reform that makes government regulation works. There’s a lot of work to do there but here’s a simple idea: Make regulators really accountable to the American people; perhaps criminal penalties for the most extreme failures to perform their jobs and financial penalties and debarment for most other serious failures. Also, if we are going to be putting government agencies in charge of protecting investors’ money, those investors ought to have the ability to recover damages when the government fails to do its job. One possibility is to set up special court to hear claims against the regulators. (Congress, of course, has also refused to accept responsibility for its part but they will be held accountable, perhaps, this November.)

Washington has also refused to do anything about the most fundamental problem with our system of bank regulation: the fact that there are multiple regulators, that banks can effectively choose which regulator they are going to have, and the regulators need to compete (since the banks fund them) for customers. Many of us were stunned when, after all the talk about whether there should be one or two regulators, the Obama administration came forward with proposed legislation last June that killed one minor bank regulator and added two more. The reason is simple politics: getting real reform in D.C. is tough.

Then there are the big elephants in the room that Congress and the administration have largely ignored. The ones on steroids of course are Fannie and Freddie–the two government-sponsored enterprises that perhaps more so than any institution on Wall Street precipitated the financial crisis (or at least poured gasoline on the fire). But let’s not forget the rating agencies that have a cozy little government-protected oligopoly, based on significant conflicts of interest, rating financial products.

Much energy has been invested in the last 18 months, not pursuing real financial reform, but beating back efforts, primarily by the Democrats, to further hobble a slow-recovering economy. The poster child for misguided reform is the Consumer Financial Protection Agency–a great-sounding government bureaucracy that would make it harder for people and businesses to borrow, raise the cost of credit and hurt job creation. In the last few weeks a lot of effort has gone into stopping provisions that would prevent American companies from managing their risks through derivatives.

The American people will hear Republicans and Democrats claim the mantle of regulatory reform and going after the fat cats on Wall Street over the coming weeks. If the Dodd bill passes, Democrats and the Obama administration will crow about how they’ve reformed greedy out-of-control Wall Street. If the Dodd bill is amended the way they want, Republicans will claim–correctly in my view–that they prevented more bailouts for big banks and consumer protection that mainly kills jobs and credit. Most likely, there’ll be a compromise and both parties will claim they ushered in real financial reform for the American people.

It’s all a farce. Faced with a crisis and the need to reform, Washington did what it does best: spin and duck.

David S. Evans teaches at the University of Chicago and the University College London.